The Key Principles of Value Investing

Stockopedia

Jun. 6, 2012, 6:26 AM

We've discussed elsewhere the paradox that while value investing is the tried and trusted method of some of the world's most famous, wealthy and influential stock buyers, for some reason it is still widely overlooked by the majority of institutional investors. We argue that this short- sightedness of the professionals works to the advantage of the motivated and determined individual investor. But where to begin? Value Investors worldwide disagree on many aspects of investing, but rarely on some fundamental principles!

Key Principle 1: Price is not value

The first key lesson for the would-be Value Investor is that the worth of a business is independent of the market price. A stock quote from day to day is only how much just the few shareholders who bother to trade that day decide their investment is worth. It is categorically not the worth of the entire company. This is the reason share prices so often spike when being bid for by an acquirer, who generally has to pay something closer to fair value. Investors should understand that the share price is like the tip of an iceberg - you can see it, but you've no idea how big or small the iceberg is below the surface unless you put on your dive suit. As Ben Graham has observed: "price is what you pay, value is what you get", meaning that big swings in the market don't necessarily mean big swings in value. When you buy a stock, you are buying ownership of a business with real assets. Should that really change just because the market is moody or plagued by worries about liquidity?

Key Principle 2: Mr Market is a crazy guy

In Graham's "The Intelligent Investor", a book which is required reading, the author conjured his now infamous parable of Mr Market. He asks the investor to imagine that he owns a small share of a business where one of the partners is a man named Mr Market. He's a very accommodating man who tells you every day what he thinks your shares are worth while simultaneously offering to buy you out or sell you more shares on that basis. But Mr Market is a manic depressive whose quotes often bear no relation to the state of the underlying business - swinging from the wild enthusiasm of offering high prices to the pitiful gloom of valuing the company for a dime. As Graham explains, sometimes you may be happy sell out to him when he quotes you a crazily high price or happy to buy from him when his price is foolishly low. But the rest of the time, you will be wiser to form your own ideas about the value of your holdings, based on updates from the company about its operations and financial position.

Key Principle 3: Every stock has an intrinsic value

The critical knowledge an investor needs to take advantage of Mr Market's behaviour and inefficient prices is an understanding of the true value of a business. The true value of a business is known as its 'intrinsic' value and is difficult, though not impossible, to ascertain. Most investors preoccupy themselves with measures of 'relative' value which compare a valuation ratio for the company (perhaps the price-to- earnings, price-to-book or price-to-sales ratio) with its industry peer group or the market as a whole. Inevitably though, something that appears to be relatively cheap on that basis can still be over valued in an absolute sense, and that's bad news for the Value Investor who prefers to tie his sense of value to a mast in stormy waters. Intrinsic valuation looks to measure a company on its economics, assets and earnings independently of other factors.

Key Principle 4: Only buy with a margin of safety

When Warren Buffett describes a phrase as the "three most important words in investing" every investor owes it to himself to understand what it is. The words are "Margin of Safety". Seth Klarman defines this as being "achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck or extreme volatility." In other words, once you are certain that you have a fair estimate of a share's intrinsic value, you must only buy the share when you are offered a price at such a discount to that value that you are safe from all unknowns. The difference between the price paid and the intrinsic value is the margin of safety. As Warren Buffett once opined "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it". In the same way, "you don't try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin". Opinions are divided on how large the discount needs to be to qualify the stock as a potential 'buy'. Indeed, the bad news is that no-one really agrees on this. In his writings, Graham noted that: "the margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price". He suggested looking for a margin of safety in some circumstances of up to 50% but more typically he would look for 33%.

Key Principle 5: Diversification is the only free lunch

Diversification is incredibly simple to understand - you shouldn't put all your eggs in one basket - but in practice, it seems to be extremely difficult to pull off. The majority of individual investors are massively under-diversified, often with an average portfolio size of only four stocks. The value investing camp splits into two on this topic. Fundamental value hunters who follow Warren Buffett tend to fall into the 'focus portfolio' camp believing that you should put all your eggs in just a few baskets and watch them like a hawk. An alternative approach is that espoused by the more 'quantitative' value farmers who seek to 'harvest' the value premium from the market. As we shall see, Graham recommended owning a portfolio of 30 bargain stocks to minimise the impact of single stocks falling into bankruptcy or distress, while Joel Greenblatt recommends a similar level of diversification when following his Magic Formula strategy.

Making Sense of Value Investing Principles

Last week, we discussed how it was good news for individual investors that making money using a value investing strategy requires the mastery of just a few principles. What should be clear now is that while intrinsic value and margin of safety make perfect sense in the context of value stock selection, defining precisely how to execute each principle requires some careful thinking and the acceptance that some nuances can only be decided by the interpretation and preference of each investor.